Where's this long-awaited recession?

published 17 October 2007

When did the world first get an inkling all was not well with the global economy? Was it in mid-May, when gold peaked at $730 an ounce? Or at the end of June, when ten-year Treasury bond yields stopped rising? Or early August, when the oil price failed to hit a new high of $77 a barrel? It's hard to say, but at some point over the summer, it seems the realisation dawned that the halcyon period of extended global growth we have seen over the last three years was ending. Not everyone thinks the ending will be nasty the consensus is for a slowdown in US growth rather than outright recession. And many, including Richmond Federal Reserve governor Jeffery Lacker, still think US interest rates should rise because the economy is "resilient", while inflation prospects are "discomforting".

But from what I'm seeing, the optimists will be gravely disappointed. Inflation may seem discomfortingly strong to Lacker, but in fact the risks of full-blown recession are such that by this time next year everyone will be fussing about deflation instead. Let me explain why I'm so pessimistic. Regular readers will remember it wasn't long ago that I was arguing that late-cycle inflation was a very real risk. Few people (MoneyWeek staff aside) agreed at the time, but by the end of this August, UK inflation as measured by the Government's favoured index, the CPI, had soared from 1.1% two years ago to a near ten-year high of 2.5%. The old-fashioned Retail Price Index (RPI), still used for most wage negotiating, is even higher at +3.7%.

It seems I was right. But not for the reasons I was expecting. I imagined what would happen would be similar to what usually happens when commodity prices rise. It works like this. First, prices of commodities go up, driven by higher global demand. Soon unions demand higher wages for their members to compensate for the rising cost of living. These higher wages feed into the higher prices employers have to demand to pay higher wage costs and it ends up in an inflationary spiral. Inflation becomes embedded, unemployment goes up and growth stagnates. Stagflation rules.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

This wage-cost-push inflation' is what happened last time there was a commodity-price-led inflationary surge, in the late 1970s and early 1980s. It's also what you'd expect today. But in the UK, unit wage costs aren't soaring they are growing at 3.6%, significantly below the ten-year average. And so another glaring difference between today and the 1970s has developed: instead of being squeezed, corporate profit margins are near record highs almost everywhere (even Japan). Wage growth has stalled. Whatever the reason be it immigration, global trade or diminished union power this fact is key to understanding what is going on in the global economy right now.

We have an entirely different type of inflation today to the kind we had in the 1980s. Wages aren't pushing firms into raising prices (wage-cost-push inflation'); rather, firms are hiking prices where necessary to maintain already high profit margins (profit-pull inflation'). A subtle distinction, but one with staggering ramifications. Why? Because it means today's inflation won't last. As soon as demand slows, firms will cut prices themselves because they can and because that's the best way to maintain sales and market share. This is not a recipe for stubborn inflation or even stagflation; we're looking at the possibility of outright deflation and the process has already begun.

Across the first world, headline inflation and factory-gate prices are already coming in way below forecasts. The US Personal Consumption Expenditure (PCE) deflator for September has just come in at 2.0%, far below August's 3.2% and way below expectations of 3.0%. The drop in factory-gate prices, known as the producer price index (PPI), has been even more spectacular, down from an annual rate of nearly 7% a year ago to a three-year low in September of less than 1%.

Now don't get me wrong. September 2005 saw especially high prices, so year-on-year comparisons exaggerate the extent of the slowdown in inflation. This September also saw the brunt of the correction in oil prices a correction so sharp and fast that oil (and hence US gasoline prices) is more than likely to rebound again in the near term. But nonetheless, the last 15 years have been typified by much lower inflation than at any time since World War II and yet today, both CPI and PPI in the US are well below even that 15-year average. This just isn't a system jammed with sticky late-cycle inflation it can't get rid of. Quite the opposite. High profit margins mean companies are more than able to cut prices very quickly given the right incentives such as a recessionary collapse in demand, for example.

So is there such a collapse looming? Yes there is in the US. And when the US sneezes, we are all likely to catch a cold. MoneyWeek readers have already been alerted to the nascent implosion of the US housing bubble. Well, last month the bubble didn't just pop', it detonated. Faced with record-high inventories of unsold new homes, a household sector with record-high debt service and financial obligation ratios, and the lowest affordability for a quarter of a century, US house builders were forced to slash prices to shift stock. The median new house price fell 9.3% in September from the month before and plunged 9.7% year-on-year; the biggest annual fall since 1970 and the biggest monthly drop ever. Existing house prices will soon follow note that the median new house price of $217,000 is pointing the way for existing house prices to fall just as significantly.

Already mortgage defaults and repossessions are rising. In California, 26,705 homeowners received mortgage default notices from their lenders in the three months ending September, more than double last year and up 29% on the previous quarter, the fastest jump since records began in 1992. Default notices (which lag the true distress levels in the housing market) are still below the 15-year average of 32,762 but it'll only take one more quarter at the present rate of growth to get there. Also, most people who receive default notices won't actually face foreclosure, because "people tend to sell a house before suffering the ignominy of letting the bank seize it", reports David Streitfeld in the LA Times. But such sellers can hardly be considered voluntary. This is how housing downturns turn into vicious cycles.

And housing activity is only just starting to wind down. In each of the past housing recessions, housebuilding as a share of GDP fell to between 3.25% and 3.75%. So far, it has fallen to 6% of GDP from a recent peak of 6.25%, so there's a long way to go. This is salutary, because not only are many economists lining up to claim that the US is (amazingly) through the worst already, but even consensus forecasts still hold that 2007 will see growth higher than the 1.6% rate achieved last quarter. In other words, we are only one quarter into the downturn and already people are thinking things will get better from here.

Yet none of this should surprise anyone. The official 12 leading economic indicators, as well as reports as diverse as the CEO sentiment survey and the National Association of House Builders index (NAHB), have warned that growth will slow. Some of these measures have not fallen so sharply since the run-up to the 1990 housing-led recession. The risks of a recurrence shouldn't be taken lightly but they are.

The options market is signalling that US equity markets are about as complacent as they ever get. Not only is the VIX sentiment indicator at nearly ten-year lows (having been well above average as recently as mid-July), but the volatility skew is too narrow and put options are no more expensive than calls. In layman's terms, at-the-money (ATM) options, both calls and puts, are too cheap. Worse, out-of-the-money options, both puts and calls, are too cheap compared to the ATM options. Worse yet, puts are too cheap compared to calls. Still don't know what I'm talking about? Suffice to say that these are historically reliable ways of judging not only investor complacency, but, more often than not, market reversals too.

In early summer, investors thought low inflationary global growth would go on forever. Then the markets' confidence was shaken as it seemed, at first, that inflation might get out of control, then that the rate of growth might slow down a bit, and now, most recently, that perhaps slower growth and stubborn inflation might co-exist. But bizarrely, US equity markets have been flooded with cash and, since the wobble in May, have decided just to keep going up ever since, however the story might eventually pan out.

But I am here to tell you that the ending may be quite different. Firstly, there is still a good chance, perhaps better than evens, that, like so many housing downturns before it (they have come around about once every ten years: 1966, 1975, 1981 and 1991), the downturn accelerates, forcing mortgage equity withdrawal out of consumption, tipping the economy into recession and resulting in more housing repossessions. That may sound unnecessarily gloomy but it has happened that way nearly every decade in the past; it's been nearly 16 years since the last one; and everything from unsold inventory overhangs to affordability are at their worst-possible readings. I defy anyone to argue that we won't have a normal downturn.

Yet even as some people come around to the view that a US recession is not only possible but even probable, most will still fret about the possibility of higher inflation. That even central bankers such as Jeffery Lacker are doing this is testament to how powerful cultural memories of this type are. But the type of inflation we have today is unlike anything from the 1970s and 1980s so unlike it, in fact, that rather than a stubborn overhang of late-cycle inflation, we should be wary of another beast altogether: deflation.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.